IDCs: Intangible Drilling Costs
Through our strategic relationships, we offer oil and gas drilling opportunities in the form of limited partnerships. Please review the information below to gain a general understanding of oil and gas investment opportunities and the tax benefits associated with IDCs. As well, please review the subsequent disclosure information of risks and fees associated with oil and gas partnership investments.
DEFINITION of Intangible Drilling Costs – IDC
Costs to develop an oil or gas well for the elements that are not a part of the final operating well. Intangible drilling costs (IDCs) include all expenses made by an operator incidental to and necessary in the drilling and preparation of wells for the production of oil and gas, such as survey work, ground clearing, drainage, wages, fuel, repairs, supplies and so on. Broadly speaking, expenditures are classified as IDCs if they have no salvage value. Since IDCs include all real and actual expenses except for the drilling equipment, the word “intangible” is something of a misnomer.
BREAKING DOWN Intangible Drilling Costs – IDC
The IDCs deduction has been allowed in the US since 1913 in order to attract investment capital to the high-risk business of oil and gas exploration. If a taxpayer makes an election to expense IDCs, the taxpayer deducts the amount of the IDCs in the taxable year in which it was paid or incurred.
BREAKING DOWN IDC Deposits
Working interests refer to a form of investment in oil and gas drilling operations in which the investor is directly liable for a portion of the ongoing costs associated with exploration, drilling and production. In a similar fashion, working interest owners also fully participate in the profits of any successful wells. This stands in contrast to royalty interests, in which an investor’s cost is usually limited to the initial investment, also resulting in a lower potential for large profits.
BREAKING DOWN Working Interests
Working interests, also referred to as operating interests, allow investors a percentage ownership of the drilling operation, functioning as a form of lease providing the investor a right to participate in drilling activities and a right to the resources produced from that activity. Along with deriving an income from the production of the resource, the investors are also responsible for a percentage of the expenses related to its acquisition.
How a Working Interest Works
All investors within the arrangement select a well operator, who then also fills a role as a working interest. The well operator, after all operating expenses have been covered, divides any additional funds between those holding a working interest, creating a source of income. Those holding a working interest may deduct certain costs, such as those associated to depreciation of equipment, when determining what will amount to a form of self-employment income.
Tax Implications of Working Interest Income
Since most working interest income is treated as self-employment income, it will generally be taxed as such. Since regular income tax payments are not automatically withheld from these funds, investors may be responsible for making estimated tax payments based on the current Internal Revenue Service (IRS) standards and rates.
Additionally, if the investor receives free resources, such as natural gas service to their property, from the company with the associated leasing rights, these amounts may also qualify as income and may be taxed as such.
Investors with working interests are often eligible for certain tax deductions based on the operating costs associated with the business. This can include business expenses of a tangible or intangible nature, such as equipment costs or utility payments.
Please consult a tax professional with regard to these matters.
Risks of Working Interests
While the idea of earning long-term income from owning a working interest in a natural gas or oil well might sound secure, the potential downside is the higher risks associated with working interest in comparison to other investment options. Limited liability royalty interests may provide an opportunity to participate in oil and natural gas investments with a lower level of risk than a working interest.
While working investments require continuous input from investors in regards to expenses, risking larger losses if expenses outweigh income, royalty interests generally require no additional funding from those investors, making additional losses beyond the initial investment less likely.
An intangible cost is an unquantifiable cost relating to an identifiable source. Intangible costs represent a variety of expenses such as losses in productivity, customer goodwill or drops in employee morale. While these costs do not have a firm value, managers often attempt to estimate the impact of the intangibles.
BREAKING DOWN Intangible Cost
Ignoring intangible costs can have a significant effect on a company’s performance. For example, let’s examine a potential decision for a widget company to cut back on employee benefits. To improve profits, the firm wants to cut back $100,000 in employee benefits. When news reaches the employees of the cut-back, worker morale will likely drop. The widget production will likely be diminished, as employees focus on losing benefits instead of making products. The loss in production represents an intangible cost, which may be great enough to offset the gain in profits created by reducing employee benefits.
An intangible asset is an asset that is not physical in nature. Corporate intellectual property, including items such as patents, trademarks, copyrights and business methodologies, are intangible assets, as are goodwill and brand recognition. Intangible assets exist in opposition to tangible assets which include land, vehicles, equipment, inventory, stocks, bonds and cash.
BREAKING DOWN ‘Intangible Asset’
An intangible asset can be classified as either indefinite or definite. A company brand name is an indefinite asset, as it stays with the company as long as the company continues operations. However, if a company enters a legal agreement to operate under another company’s patent, with no plans of extending the agreement, the agreement has a limited life and is classified as a definite asset.
Value of Intangible Assets
While intangible assets don’t have the obvious physical value of a factory or equipment, they can prove valuable for a firm and can be critical to its long-term success or failure. For example, a business such as the Coca-Cola Company wouldn’t be nearly as successful were it not for the high value obtained through its brand-name recognition. Although brand recognition is not a physical asset that can be seen or touched, its positive effects on bottom-line profit are the driving force behind Coca-Cola’s global sales year after year.
Reporting Intangibles to the IRS
Businesses may create or acquire intangible assets. For example, a business may create a mailing list of clients or it may establish a patent. However, another business may eventually buy or acquire either of those intangibles. If a business creates an intangible asset, it cannot write off its value on its income tax return, but if a business acquires the asset, it may claim the cost as a capital expense.
To illustrate, if a business takes out a patent, it may claim the cost of paying inventors, filing the patent application, hiring a patent lawyer and other related costs as business expenses. It may not, however, evaluate the patent and claim that amount as a business expense as well. However, if another business buys the patent, it may write off the cost of the patent. The IRS requires businesses to amortize the cost of intangibles, which means to write them off incrementally over a number of years.
Tangible Vs. Intangible Assets
Tangible assets include both real and financial assets. Real assets include machinery, vehicles, buildings and equipment, while financial assets include those that derive their value from a contractual claim, such as stocks and bonds.
A drilling technique in which a well is bored at multiple angles. Directional drilling most often refers to drilling at non-vertical angles, including horizontally. It is used both to retrieve oil and natural gas buried underground, and is useful in situations in which the shape of the reservoir is abnormal. It is also used to adjust pressure created by gas in mines (degasification).
BREAKING DOWN ‘Directional Drilling’
As a technique, directional drilling allows oil and gas well operators to approach a potentially productive area without the need for a well to be drilled directly above that area. A central site can service multiple well bores that reach multiple locations at non-vertical angles. This reduces the number of well facilities that must be built and maintained. Not needing to build new wells may also lead to the exploration of smaller reservoirs that would otherwise be uneconomical.
Early directional drilling involved pointing the drill bit at an angle other than vertical, resulting in a straight line away from the well. Modern drilling techniques allow the use of drill bits that can bend; allowing engineers to adjust the direction the well is drilled in to a certain degree. This can be accomplished through the use of hydraulic jets
Directional drilling is used in the development of mines in order to reduce the risk of potentially dangerous gas ruptures. In-mine drilling techniques allow companies to create bore holes far in advance of the mine face.
While the fundamental concepts of directional drilling date back to the 19th century, it has become a more popular technique as computer-aided technology has become more common. The angle of the drill bit being used to bored the well can be adjusted by a computer using GPS signals to pinpoint the location of an oil and gas field. Engineers create 3-D models of the field to determine the best location for the well, and the best approach for the bore to follow.
The energy sector is a category of stocks that relate to producing or supplying energy. This sector includes companies involved in the exploration and development of oil or gas reserves, oil and gas drilling, or integrated power firms.
BREAKING DOWN ‘Energy Sector’
Performance in the sector is largely driven by the supply and demand for worldwide energy. Energy producers will do very well during times of high oil and gas prices, but will earn less when the value of energy drops. Furthermore, this sector is sensitive to political events, which historically have driven changes in the price of oil.
Source: Intangible Drilling Costs – IDC Definition | Investopedia
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